Embracing Divergence

According to the Federal Reserve Bank of Atlanta’s “GDP-Now” forecast, the US economy is expected to have expanded at a blistering 7.8% real rate during the second quarter (Q2) of 2021.[1] Abetted by that powerful tailwind, the consensus of Wall Street analysts expects second-quarter S&P 500 earnings to have risen nearly 64% compared with the same quarter last year.[2]

Yet, the bond market has been telling a different story. Yields have plunged nearly 50 basis points from their recent highs and the yield curve has flattened sharply, typically a sign of slowing growth and weaker corporate profits ahead.

Who is right? In fact, both the bulls and the bears have strong cases. And because it will take longer to sort things out, the implication is more volatile markets in the second half of 2021. Investors must now embrace divergence.

Let’s begin with economic activity. Even though growth is strong, forecast revisions are beginning to dip. The aforementioned “GDP Now” forecast peaked at 8.6% before falling back.[3] The latest high-frequency measures of manufacturing and surveys tell a similar story. The best of 2021 growth may be behind us.

Mixed signals

Behind the downward GDP revisions are some noteworthy concerns. Doubts have arisen about whether any US infrastructure bill can muster the necessary votes in Congress. If not, US fiscal tailwinds will fade by early 2022. Supply-side hindrances are also persistent. Anecdotal evidence suggests that firms may be reluctant to induce workers back to the job with higher wages, partly for fear of crimping profit margins. As a result, output may respond sluggishly to demand. Semiconductor chip shortages continue to hinder manufacturing, above all for automakers. Central-bank tapering discussions, in the United States and elsewhere, have also raised questions about 2022 growth.

At the same time, corporate profits are booming. Compared with three months ago, the estimated growth of S&P 500 earnings has risen over 11 percentage points, reflecting economic reopening, fiscal stimulus, surging commodity prices, high levels of operating leverage and easy comparisons to the 2020 earnings “washout.”[4] The number of S&P 500 companies reporting positive guidance (a sunny outlook for profits) for the second quarter will be the highest on record.[5] The biggest winners are the most cyclically sensitive sectors, including energy, basic materials and financials, followed by information technology and communications. Already, the big banks have delivered strong results. Indeed, the only sectors to see downward consensus earnings forecasts for the second quarter have been utilities and consumer staples.

Moreover, despite robust Q2 equity market gains, advances in the major US indexes failed to keep pace with upgrades to earnings forecasts, meaning that market multiples declined over the past three months.[6] Advancing share prices have benefited from robust fundamentals, not excessive investor exuberance.

Asset prices move on expectations

Investors react to news. Their job is to uncover surprises in backward-looking corporate earnings reports as well as in forward-looking market forecasts. At times, the two are aligned, for instance earlier this year, when growth was strong and accelerating. In that environment, cyclical rotation led equity markets higher even as bond yields rose.

But sometimes the future differs from the past. Then, tensions surface. Do upside surprises from the recent past trump downward revisions to future growth and earnings? Or is it the other way around?

Investors have recently shifted their vision to what lies ahead. Rotation into cyclical and value shares has stalled. Leadership has shifted back to “stable growers,” such as large-capitalization information technology stocks, and more defensive quality styles. Bond yields have fallen. Investors are preparing for slower economic growth and weaker earnings.

But that might not prove correct. As more parts of the world economy are successfully vaccinated, successive waves of economic reopening will take place. New growth impulses could emerge from Europe, Japan, and emerging markets. To be sure, there may be bumps in the road, given the infectiousness of the delta variant, as seen by the recent ban on spectators for the Tokyo Olympics. Yet most vaccines appear to be effective at reducing severe infection, even for the delta mutation. Nevertheless, availability and willingness to vaccinate will remain important to investor perceptions of global growth.

Will governments really listen?

Also, while the odds of another US fiscal stimulus have faded, so too have the probabilities of tax hikes on capital gains, dividends, or wealth. Indeed, Washington gridlock applies even more to taxes than spending. And despite the Federal Reserve’s willingness to engage “taper talk,” the European Central Bank has now adopted a more symmetric inflation target, which suggests its easy policies will be extended for longer.

And let’s not forget earnings. The “backward-looking” Q2 earnings season is poised to deliver stellar results for many cyclicals. High oil, coal and other commodity prices will boost revenues in the energy and materials sectors. Robust capital markets have underpinned financials. Sluggish hiring, meanwhile, suggests that in many industries rising output has lifted productivity. Accordingly, in many industries profits will expand substantially faster than revenues as “operating leverage” is exploited.

In sum, at the middle of 2021 the global economy and capital markets have reached an inflection point. Second derivatives of economic and earnings are rolling over, but growth rates will remain high relative to history until such time as full employment is restored and operating leverage is exhausted.

Second derivatives are key barometers for markets. Sometimes they mark directional turning points. More often, they create tension between the fundamentals of the near past and those of the future. Volatility and dispersion of returns within asset classes tend to increase when the future and the past clash. Those outcomes create opportunity for tactical portfolio re-positioning, careful security selection and greater risk management.

Welcome to a new investment backdrop. It is time to embrace divergence.

For additional market and investment views for the second half of the year read:?

US:?Franklin Templeton’s Global Investment Outlook: Guarding for Inflation and Searching for Quality?and?Franklin?Templeton?Fixed Income?Views:?The Fed’s long, hot summer.??

Non-US: Guarding for Inflation and Searching for Quality and Franklin Templeton Fixed Income Views:?The Fed’s long, hot summer.??

What Are the Risks?

All investments involve risks, including possible loss of principal.?The value of investments can go down as well as up, and investors may not get back the full amount invested.?Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.

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[1] Source: Federal Reserve Bank of Atlanta, “GDP Now” as of July 9, 2021. There is no assurance that any estimate, forecast or projection will be realized.

[2] Source FactSet, Earnings Insight, July 2, 2021.

[3] Source: Federal Reserve Bank of Atlanta, “GDP Now” as of July 9, 2021.

[4] Source: FactSet, Earnings Insight, July 2, 2021.

[5] Ibid.

[6] Source: Credit Suisse. Return Decomposition Monthly. July 2021.?